The Election-Year Effect: For Now, 2008 Stock Market Bucks the Trend

by Wayne A. Thorp

While 2008 is a presidential election year, the stock market apparently is taking no notice.

Since 1950, stocks have risen in 13 of the 14 presidential years, according to the Stock Traders Almanac. Likewise, according to the Seeking Alpha Web site (www.seekingalpha.com), the S&P 500 has gained an average of 8.6% in the fourth year of a presidents term and 3.8% in the fourth year of a presidents second term.

However, so far this year the market has been unable to overcome a slumping housing market, rising food, oil and gasoline prices, and an anemic economy. All of these factors have contributed to the S&P 500 being down 7.3% through the first week of June of this year (Figure 1).

As one might expect, there has been a carryover effect on the performance of the AAII stock screens: of the 56 stock screening methodologies tracked at AAII.com, only 20 are up for the year, although 43 are outperforming the S&P 500 year-to-date.

Mid-cap issues are again enjoying stronger performance relative to small- and large-cap stocks. And in terms of style, growth strategies are outperforming value for the year.

Stock Screen Results

Table 1 summarizes the performance and variability of AAIIs stock screens, which we track using Stock Investor Pro, AAIIs fundamental stock screening and research database program. AAII tests and tracks a wide range of screening methodologies and has backtested performance results of hypothetical portfolios invested based on these individual approaches back to the start of 1998. The methodology used to calculate the performance is explained in the box on page 26. For more information on these screens, visit the AAII Stock Screens area of AAII.com.

The table also offers index performance data for the same periods. The screening methodologies listed in the table are grouped by stylevalue, growth & value, and growthwith additional specialty and sector screens broken out separately. Within each grouping, we rank the strategies in descending order by year-to-date performance as of June 6, 2008.

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Mid-Year Leaders

Thus far for 2008, the group of top-performing screening strategies has a fresh look compared to recent years.

Topping the list for year-to-date performance is a strategy that hasnt before made it to the top, the growth and value strategy of Philip Fischer, with a gain of 22.3%.

The Fisher screen identifies non-dividend-paying stocks with a history of net margins (net income divided by sales) exceeding industry norms, improving sales, and reasonable price/earnings valuations relative to estimated earnings per share growth.

The Fisher approach has seen mixed performance since 1998. In 2001, the screen was the third-best overall performer, with a 70.7% gain and it gained 78.1% in 2003. These two years alone translate into a cumulative gain of over 200%, yet the Fisher methodologys cumulative gain since the beginning of 1998 is only 171.7%. In comparison, the S&P 500 is up a total of 40.3% over the same period. Looking at the companies currently passing the Fisher screen, biotech firms dominate the list.

Martin Zweig returns to the top as the best long-term performer. This growth and value screen has a cumulative gain of 2,397.4% since the start of 1998. Slipping to second place overall is OShaughnessys Tiny Titans approach, which is down 20.4% for the year but still has a cumulative gain of 2,337.7%.

The Martin Zweig approach is currently down 0.8% for 2008, placing it roughly in the middle of all growth and value screens. The screen identifies companies with strong growth in earnings and sales, a reasonable price-earnings ratio given the companys growth rate, insider buying (or at least a lack of heavy insider selling), and relatively strong price action. Companies in the jewelry and silverware industry factor heavily among those currently passing the screen.

Value Winners

Value-oriented investment approaches, in general, have been underperforming growth strategies for 2008. Eight of the 18 screens in the value category have positive year-to-date returns through the end of May.

Leading the way in the group for 2008 is the P/E Relative screen with a year-to-date gain of 14.6%. The relative price-earnings ratio approach looks back at the relationship of the price-earnings ratio of a stock to the price-earnings ratio of the overall market. The price-earnings relative is determined by dividing a companys price-earnings ratio by that of the market. The P/E Relative screen looks for stocks trading at prices below their valuation estimates based on trailing earnings per share and five-year average price-earnings relatives. The screen also requires upward revisions in annual consensus earnings estimates over the last month.

The Graham Enterprising Investor approach remains the top long-term performer among the value-oriented strategies, with a cumulative gain of 971.1%. After turning in the best overall performance in 2006 and being the top-performing value methodology in 2007, the Graham Enterprising screen is again generating a respectable return with a 9.6% year-to-date gain (the second-highest among all value strategies). This approach looks for unpopular dividend-paying companies with low price-earnings and price-to-book ratios that are exhibiting positive earnings and have a reasonable amount of long-term debt relative to net working capital (current assets less current liabilities). Last year the screen went most of the year without generating a single passing company; this year only one or two companies have passed each month, making it difficult to follow if you want to build a portfolio.

Growth Winners

Another screen that has lived in relative obscurity for most of its career is the Inve$tWare Quality Growth approach, which leads all growth strategies with a year-to-date gain of 8.9%. It is one of only two growth strategies so far this year with a positive return. The screen is based on the National Association of Investors Corporations (NAIC) philosophy of selecting reasonably priced stocks of good quality companies that merit further investigation. Since 1998, this screen has generated a cumulative gain of 88.9%. The majority of companies currently passing this screen are in the services and technology sectors.

Looking at long-term performance, the original CAN SLIM methodology continues to have the segment-leading cumulative gain1,419.5% since the start of 1998. This approach combines fundamental price-oriented factors to isolate companies with strong price and earnings momentum, and tends to identify small-cap growth stocks. For the year, this screen is down 6.3%.

Risk and Turnover

When measuring the performance of any individual investment or investment approach, you also need to consider the risk of the asset or strategy. Just because an approach posts strong annual gains does not necessarily mean that it is right for you. Your own risk tolerance should also play a role in deciding the types of stocks to add to your portfolio.

Table 1 includes Monthly Variability columns, which report the greatest monthly percentage gain or loss as an indication of volatility that occurred over the last 10½ years.

The Monthly Variability columns also report the monthly standard deviation over the full study period. Standard deviation is a measure of total risk, expressed as a monthly change, which indicates the degree of variation for a strategy over the test period. The higher the standard deviation, the greater the total risk of the strategy. Ideally, higher returns compensate you for taking on higher levels of risk.

The Murphy Technology growth screen has the highest monthly standard deviation of the methodologies AAII tracks at 14.5%. However, it also has the lowest cumulative gain of 45.5%. On the flip side, three of the top-10 overall screens also rank in the top 10 in terms of monthly standard deviation.

The Monthly Holdings columns provide data on portfolio holdings over timethe total average number of stocks that were in each portfolio on a monthly basis over the last 10½ years, and the average percentage turnover from month-to-month.

While the backtesting methodology we use to calculate the hypothetical performance of these screens does not factor in turnover, a high-turnover portfolio will incur greater trading costs than a low-turnover portfolio (all else being equal). This, in turn, will have an adverse affect on the portfolios overall performance. The Estimate Revisions Up 5% screen has the highest monthly turnover at 92.4%. This means that, on average, only 7.6% of the same stocks pass the screen from one month to the next. Coincidentally, this screen is also has the third-highest cumulative return since the start of 1998.

Conclusion

The first step of stock screening is to establish a set of practical rules to identify a collection of potential investment opportunities. The next step is to have the discipline to follow these rules instead of allowing your emotions to dictate your buy and sell decisions.

The AAII Stock Screen strategies are interpretations of the investment approaches advocated by prominent investment professionals or are based on basic investment principles backed by academic research and real-world results. Examining the characteristics of an investment methodology reveals many of the practical problems you may run into when trying to develop your own disciplined approach to investing.

One pitfall to avoid when looking at the performance of these strategies is to simply select the methodology with the highest return and blindly buy the stocks that pass the screen each month. Instead, it is important to gain an understanding of the forces that influence the portfolios performance and how these strategies might perform during current and expected future economic and market environments.

Most importantly, however, remember that screening is only a first step. Due diligence is needed to evaluate a stock to decide if it has the necessary financial strength and the risk and time horizon qualities required for your portfolio.

For further information on these approaches, consult the AAII Stock Screens area of AAII.com.

How We Evaluate the Screens

The AAII screens are an educational resource for our members, designed to expose you to a wide range of stock investment approaches, as well as the individual companies that pass each investment screen month-to-month. We report the performance of hypothetical portfolios of the stocks passing the individual screens for comparison to illustrate how various stock selection strategies perform over differing market conditions. We do not intend this to be an enticement to invest based on any one methodology nor is this an endorsement of any specific investment approach.

Each month, over 50 separate screens are performed using AAIIs Stock Investor Pro software. Strategies run the gamut from pure value- and growth-based approaches, small-cap to large-cap, to some specialty methodologies, and many that fall in between.

How We Calculate Returns

The performance of the stocks held in hypothetical portfolios for each screen are tracked on a monthly basis. At the end of each month, we run each screen and the companies passing each screen are purchased in equal dollar amounts using the month-end price. We assume that we hold these stocks for one month, selling all the stocks at next months closing price. The performance of a portfolio for that month is the average percentage change from month-end close to month-end close. These monthly performance figures are used to generate the cumulative gain for a screen. We then run the screen with the new month-end data and repeat the process all over again, investing all proceeds. Sell rules are the same as buy rules. Thus, a stock is sold (no longer included in the portfolio) if it ceases to meet the initial criteria, and new stocks are added if they qualify. Stocks that no longer qualify are dropped even if the strategist behind a particular approach suggests different sell rules versus buy rules.

Keep in mind that the impact of factors such as commissions, bid-ask spreads, and time slippage (time between the initial decision to buy a stock and the actual purchase) are not considered. This overstates the reported performance, but all approaches are subject to the same conditions and procedures. Higher turnover portfolios would typically benefit more from these simplified rules.

The only time a given approach is in cash (not invested in any stocks) is when no companies pass the screen in a given month.

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In This Issue

July 2008 Issue

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The American Association of Individual Investors is an independent, non-profit corporation formed for the purpose of assisting individuals in becoming effective managers of their own assets through programs of education, information and research.